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IRS Targets Loopholes for $415 Billion Business Owner Tax Break

(Bloomberg) -- The Internal Revenue Service provided some long-awaited answers for business owners hoping to dodge the limits on a juicy new tax break.

The IRS’s proposed regulations make it clear that the agency considers a planning technique known as “crack and pack” to be abusive. The move had been eyed by professional service providers, such as law and accounting firms, to get around income limits set for pass-through businesses, whose income is reported on their owners’ personal returns.

Under that strategy, business owners split their firms into different entities to lower their tax bills. For example, a law firm would put all the secretarial staff in one entity and the lawyers in another to get the full deduction for the income earned in the administrative entity.

“You can see in the regulations that they were very concerned about anti-abuse provisions, people gaming the system,” said Andrew Howlett, counsel at the law firm Miller & Chevalier in Washington.

The pass-through break under President Donald Trump’s tax law spurred tax professionals to circulate proposals and riff on each other’s ideas, as the industry looked to coalesce around strategies that would save their clients money.

Trump and Republican leaders have said middle-class Americans and small businesses would be the biggest beneficiaries under the $1.5 trillion tax cut. But the strategies under consideration to take advantage of the 20 percent pass-through deduction showed how top earners could potentially reap the biggest gains.

All taxpayers who earn less than $157,500, or $315,000 for a married couple, can now deduct 20 percent of the income they receive via pass-through businesses from their overall taxable income. If taxpayers earn above those amounts and aren’t service professionals, they must meet tests to take the full deduction -- the size of their deduction depends on how much they pay in employee wages or how much they’ve invested in capital like real estate.

For “service professionals,” the break fully phases out if they earn more than $207,500 if they’re single, or $415,000 if they’re married.

Treasury officials said during a call with reporters on Wednesday that a law firm consisting of multiple, commonly-controlled entities, in which one entity provides its specified services back to the law firm, would be subject to the income limits on the services. The officials added that the proposed regulations also target relabeling employees as independent contractors.

The proposed regulations provide some answers about what’s a service business, a key issue for hundreds of thousands of businesses wondering if they qualify. The rules make clear, for example, that highly paid veterinarians wouldn’t get the tax break. They would be classified as health professionals, excluded from the tax break along with physicians, pharmacists and nurses if they’re over the income limits.

The same goes for lobbyists, who the rules classify as a “consulting” service business. Top-earning reality stars are also specifically mentioned as excluded from the deduction.

Real Estate Agents

Still, several industries scored victories. Though financial services were included as a service business in the law, the rules say that category doesn’t include bankers who take deposits or make loans. Well-off financial advisers and investment bankers are still excluded under the rules.

The rules also define brokerage services, another excluded category, narrowly. It doesn’t apply to real estate agents and brokers, and insurance agents and brokers, who can take the deduction. But securities brokers above the income limits are excluded.

“The regulations illustrate the unfair and arbitrary lines that Congress legislated and that the IRS then tried to implement,” said David Kamin, a tax law professor at New York University.

Headhunters, Hairdressers

The IRS did specify that businesses with a relatively small amount of “specified” service income won’t be hit by the limits.

Business owners, including service providers, whose annual gross receipts are less than $25 million a year -- with less than 10 percent of their income coming from the service part of their business -- won’t be subject to the income caps. That could provide relief for contractors, headhunters and hairdressers.

The proposed regulations also specify that pass-through owners with income from multiple legal entities won’t have to restructure to take advantage of the deduction. Many pass-throughs are comprised of a series of related entities. A common structure is a unit that holds the operating business with another that conducts payroll activities. It had been unclear whether those businesses could aggregate to maximize the break.

Treasury plans on coming out with additional rules, including some to address a loophole in the tax law under which highly paid professionals, such as investment managers, doctors and lawyers, could form cooperatives to take advantage of the deduction, according to the officials.

The estimated cost of the pass-through deduction is $415 billion over the coming decade, according to the nonpartisan Joint Committee on Taxation. The tax break could be even more expensive if IRS regulations can’t keep gamesmanship to a minimum.